Wednesday, May 21, 2008

Doomed to Gloom

Pull up the car of US economy – a possible recession is round the corner. Wash it at the White House with President Bush’s $150 billion financial stimulus package, or at the Fed that continues to cut interest rates – to up consumer spending that makes up for 70% of the American demand. Whatever is the remedy, US economy is supposed to slow down. But this is nothing new – the US has suffered two downspins since 1991. Yet this time, the FIRE (Finance, Investment, Real Estate) – as an economist shortens it – is on.

Rising asset prices and novel financial instruments have helped Americans get more debt – irrespective of whether they deserve it or not. Now, if they owe a bank say some $2 trillion, then they own the bank. And all this allegedly began a decade back with subprime mortgages, home loans sold to those who have murky credit history or with incomes not big enough to buy the house they wanted. Initially it was colored as a Good Samaritan exercise to allow everyone get their dream home. But in all this, a fundamental was lost out: gifting isn’t all that tough, but recovering it is. Lower lending standards shot up house prices that borrowers thought would help them easily refinance their way out of any trouble. At teaser rates and with almost no income verification in granting those mortgages, homes became affordable paradises. But when house prices peaked, speculators also expected a slump. And so it did and now, as the Economist points out, some 9m of those borrowers ‘owe more than their houses are worth’ and a million homes are foreclosed by lenders; this fall, by all rosy standards, will continue. Even if prices stop falling, American borrowers need to amass enough wealth to get their assets back in shape; and that’s not going to take months, but years.

For those homeowners, there’s mixed gloom. Unemployment rate in April declined just by 0.1% and the job-cuts were nearly just 25% of March’s. But it was the fourth consecutive month of companies clipping jobs. So, obviously, spending will come down and IMF doesn’t seem to have been wrong in predicting a recession in US in 2008 or as some say, it is already in one. This unemployment rate is in turn connected with the dip in house prices. As real estate prices plunge, homeowners lose their potential to borrow against the value of their homes. So their spending slumps. Uncertainty prompts banks to grow tighter with their greenbacks and families get saddled by debt, forcing many to live within their incomes. Fewer paychecks will be dispatched, as companies cut jobs and working hours. So ultimately the real disposable incomes are squeezed, spending falls and downturn becomes predictable.

Food prices too have done their bit towards recession; it was not gold or oil prices that jumped up the most, but wheat prices rose the most by 82% in 2007. US seems to nicely fit with the definition of recession as “significant decline in economic activity spread across the economy, lasting more than a few months.” But sometimes one’s loss is to another’s benefit. US slowdown would dip the demand and so China’s exports to US will decline. And this would help the overheating Chinese economy cool off. Nonetheless, as US economy is so tightly linked with world’s financial markets, a slowdown there would definitely spread as a financial epidemic across the world. No country is immune to that but they can only hope that the impact is not devastating.

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